Fixed vs. Adjustable Rate

The idea of fixed vs. adjustable rate loans isn’t all that hard to understand. The point and the implications might need a little more explaining. A fixed rate loan (whether it be a mortgage, a term loan, a line of credit or whatever) is one where the interest rate that will be charged over the life (known as the “term") of the loan is fixed. An adjustable rate loan is one where it will vary over the passage of time.

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The difference between fixed and adjustable rates really only become vital when we are considering long term loans like mortgages. The reason is that when the lender makes a 30 year loan, they are taking a risk on future interest rates. If interest rates go up then they are not making on this loan what they could have done on a new one. If interest rates go down, they will of course be making better money than they could have, but at that point the borrower will probably refinance.

With an adjustable rate loan the interest rate will change - that is, not be fixed for the whole term. There are all sorts of variations, like 1 year ARMs (adjustable rate mortgages), 3 and 5 year ARMs and so on, and all sorts of indexes of interest rates that the price can follow, like 1 year T-Bills, COFI and so on. But the important point is that the risk of a change in interest rates has been transferred from the lender to the borrower.

That is what is at the heart of the fixed vs. adjustable rate question. For when there is a transfer in risk in financial markets there is always a change in price. As the lender has less risk under an ARM, the interest charged is less than under a fixed rate loan: but, at the risk of the price of the loan changing with the wholesale markets.